How to Invest in Oil & Natural Gas
We embark on this discussion as a word of caution, but more importantly, as a guide to help fledgling Small Producers gain a better understanding of oil and gas exploration and of the reality of what it takes to be profitable. In general, we strive through all our communications not only to inform on drilling progress and production, but also to instruct on where we’ve been, where we’re headed, and about the state of the industry. In addition, we attempt to provide an education on the latest exploration techniques that are being employed and at our disposal.
Guiding Principles for Small Producer Profitability
Our desire is to provide invaluable insight from our experience so that the Small Producer will fully understand that it is a quite complex endeavor to be a direct participant in oil and natural gas wells. We wish to impress on the reader how essential it is that any well investor not only implements a structured business plan that is both consistent and disciplined, but also that the investor recognizes the necessity of taking a long-term view. Moreover, there needs to be a realistic expectation of what can be achieved by drilling for oil and natural gas.
We cannot over-emphasize that drilling oil and gas wells is a very risky enterprise, especially for the inexperienced and uninformed. Men were sent to the moon in 1969, but now, forty-eight years later, we are still physically unable to look three miles or even a half mile into the earth and know with any great certainty what is truly down there. Although the risks are many, the potential rewards are significantly greater, and by employing a disciplined strategy, one should expect to consistently beat the “odds” and reap exceptionally high returns.
Thus, we come to our basic objective, which is this: “To provide an investment structure that enhances the rewards of being a Small Producer by minimizing the associated risks so as to maximize the return on investment (ROI) to levels greater than are generally achieved through any conventional investment means.” In other words, our job is to assay the risks and reduce the Partnership exposure to these risks as much as humanly possible using economic analysis, state-of-the-art technology, and through wise portfolio management strategies. Lastly, we purpose to provide good communications on all aspects of prospect development and production.
The Optimum Strategy – an overview
When you hear of a $7.5 million well producing 11,000 mcf of gas per day plus 1100 barrels of oil per day (17,600bcfe), or $110,000 gross earnings per day @$3.00/mcf and $70/BO, you ask yourself “why can’t I be so lucky to get on a producer like that?” The fact is most of us were drawn to this business from hearing stories of blockbuster wells like this. All of us have dreams of hitting it big despite huge risks and cashing in with fabulous returns. Obtaining a 35% per month return as we did with our Beach House#1 well (2003) or Doberman Offset well (2006) takes a bit of luck and is certainly realistic and achievable in today’s energy climate, but the probability of making this kind of discovery is exceedingly slim.
However, by doing the right homework and implementing a smart investment strategy it is quite feasible for any Small Producer to accumulate a well portfolio that nets a monthly return close to 2% through payback.
The bottom line is this: success in the oil and natural gas business really has nothing to do with luck, but rather more to do with a controlled and methodical implementation of a strategy that addresses and accounts for the high degree of risk when drilling for these precious commodities. Through nearly seventeen years of experience of participating in and managing working interest investments in more than one hundred and fifty prospect drillings, we have seen just about everything and have been able to develop a conservative and very profitable strategy which has led to consistently high returns. This “winning” strategy has worked for us by reliably compensating for the high-risk factors. Contrast this to investing in just one or a few individual wells or, as we like to refer to it, taking the “one-shot approach” that usually is a prescription for failure.
Industry Knowledge and Experience
We believe that our knowledge of the industry and experience uniquely qualifies us to introduce you to the potential rewards of becoming a Small Producer. We hope to facilitate your understanding of our investment strategy, so you can similarly achieve rewarding results that can be replicated year after year. One aspect of our strategy is this diversification mantra: “diversify-spread-diversify”. Conceptually this is not a new idea by any means, but in the oil and gas business it isn’t just a prime component of our strategy for success – it is the strategic-imperative to prevail for the long-term.
The goal then is to participate in a multiplicity of well prospects and create a well portfolio that blends discovery wells, offset wells, and field redevelopment projects.
If there is nothing else that you take away from this message it must be this, given the present state of the industry and the current level of accuracy of the latest verification tools, the industry average completion rate is roughly 49%. Consequently, one should reasonably expect and count on reaping only about a 50% completion rate when drilling exploratory wells in the mature, multi-target areas such as are currently available within the continental United States. We are always mindful of this truth in our well selection process and have made it a guiding principle in devising this investment strategy.
Strategic Planning
Therefore, an important part of the stratagem to becoming a successful oil and gas Small Producer is this; anticipate by planning accordingly that more than likely half the wells you drill are going to be non-commercial, and that the other half that are commercial will yield widely varying rates of return from marginal to superlative. To compensate for these facts, one must participate in as many wells as possible while being very selective relative to economic probables and potentials of the prospect and the reputation or track record of the Operator. It is very important that no one well has the responsibility of paying more than its reasonable share of a portfolio return each year.
Prospect Selection Process
The “prospect selection process” is another crucial element of a successful well, or prospect investment program. As the Small Producer progressively improves on his completion rates, production rates, and the ultimate accumulation of recoverable reserves through successive “wins”, a snowballing effect takes affect. Correspondingly, one’s risks progressively diminish through this process. The ability to select and secure better and better prospects also improves as this cycle of success compounds.
To win any battle, you must know and understand your opposition. So, it is in this enterprise, there must be a constant analysis of what causes dry holes, or non-commercial wells. In addition, there must be a relentless emphasis on continuous improvement or the implementation of Kaizen to one’s prospect verification techniques and prospect selection protocol before, during and after every well drill to understand how one might have won, or why the battle may have been lost in the exploration for black gold and natural gas. We are convinced that by tracking and analyzing the drilling and production histories of all our wells that such a knowledge base has brought us to our present level of success. And thus, by tapping this knowledge/experience base we hope to achieve even greater successes far into the future. This is what every Small Producer should do to similarly be successful.
One needs to realize that to even have a chance at being profitable a pay zone or reservoir must contain these characteristics:
- The reservoir must have a well-defined trap with top and bottom seals that maintain pressure and prevent transmigration of the hydrocarbons.
- The porosity must be large enough to contain economical volumes of oil and natural gas.
- The permeability must be enough to allow the reservoir to flow at an economically feasible rate.
Understanding how the Industry verifies these three characteristics before drilling is crucial to be an informed Small Producer. Understanding to what degree a prospect fulfills each of these conditions allows one to better assess the risk associated with the exploratory well for that prospect. Since Edwin L. Drake drilled the first oil well in 1859 in Crawford County in Northwestern Pennsylvania, the oil industry has been trying to address each one of these characteristics. However, even now the industry has only been successful in verifying the first of these characteristics with any degree of certainty before a well is drilled. Using 3-D seismic, geologists and geophysicists can predict with reasonable accuracy the presence of a potential underground reservoir that has good and effective seals on all four sides and should be able to maintain pressure and thus trap oil and/or natural gas. 3-D seismic, which came to prominence in the 1990’s with the explosive growth of computer hardware, has proven to be the breakthrough in finding viable oil and gas reservoirs.
When we find attractive, prospective reservoirs with 3-D seismic that are in relatively close proximity to producing wells, the geologists and geophysicists can only speculate that the reservoir they found should have the same or similar porosity and permeability of nearby wells (this is called well control). Herein lays the core of all speculation and risk in oil and gas exploration. Although we have seen recent improvements in the accuracy of finding reservoirs, scientists still have no way of determining what is in the reservoir until the exploratory well is drilled into it. However, as mentioned, they can determine with reasonable accuracy if the reservoir has four walls and what the physical dimensions of the reservoir are.
The other two characteristics can only be speculated upon using data from nearby wells (well control) that have drilled through an analogous reservoir near a prospective drilling location. The track record of how accurate the nearby wells are at predicting the porosity and permeability of the prospect well totally depends on what type of reservoir is being pursued. For example, a simply-formed blanket sand that has a large footprint is very good about revealing porosity and permeability numbers. The study of nearby wells can predict with great accuracy whether the sand is a blanket sand like a deep-water deposit or channel sand like a river deposit that will be limited and will not likely predict porosity and permeability in any future offsetting prospect well(s). Similarly, a field that is complexly deformed is generally very thick but not very wide; therefore, the footprint is small, and the offsetting wells may or may not have similar trapping potential.
This inability to determine accurately what the actual makeup of the reservoir is the fundamental of what makes exploration so risky.
Advanced Technology
The primary goal of research and development in the hydrocarbon exploration industry is to try to improve on what little information we have on the composition of reservoirs before we drill into them. Advanced technology can help us look inside a potential reservoir and give us the ability to speculate with greater validity on the presence of oil and gas. Much technology is still under development, and we believe in applying breakthrough predictive tools that will further reduce risks with exploratory wells.
We are hopeful that burgeoning technology will revolutionize the industry sometime this decade like 3-D seismic did in the 90’s, but right now we depend on 3-D seismic and the experience of the geologists and geophysicists to predict what a reservoir contains. The state of our industry today is that with our limited ability to preview what is in the ground below in the proposed areas of activity, roughly half of the exploratory reservoirs one finds are not capable of producing commercial quantities of oil and/or natural gas. But even with this limitation, the oil and gas business is one of the most worthwhile businesses in the world. One can only imagine what will happen to industry accomplishments through discovery improvements with technological advancements.
Concerning Operators: The Small Producer must know his operator(s). You can have one of the greatest discoveries, but a sloppy or unscrupulous operator can make a cash cow become a money pit. Make it a practice to deal only with operators with proven track records and monitor via forensic audits any operations that are suspect.
Now that you understand in broad measure the risks, let us share with you how one can apply this knowledge to possibly generate returns that will best any conventional investment vehicle – be it stocks, bonds, mutual funds, or real estate. The obvious question arises: how many wells represent good diversification?
If all the prospects qualify to the preset verification parameters, the minimal number of wells for diversification seems to be “dozens” of wells.
The reason for specifically choosing twenty wells as a minimum spread in our example below is based on a probability study of the sixty Y2004 wells that we have tracked. This study revealed that if one had invested in just one well there was a 51% probability of not getting one’s money back in six years (@30% tax bracket and 15% annual depletion). The probability decreased to just 3% at ten wells. The risk of not getting one’s money back became virtually 0% by investing in any twenty of the wells. This conclusion was reached because of that year’s well mix 1 in 10 wells was successful enough to pay for seven to ten other wells. Therefore, we can say that if you take your annual well investment budget and spread it over at least twenty geo-substantiated and economically justified prospects a year then a 2-4% net return of investment a month should not be an unrealistic expectation. We demonstrate an annual ROI calculation for a twenty well portfolio investment through the following hypothetical example.
50% Completion Rate Scenario
| Well Name | % Return Before Tax | Well Name | % Return Before Tax |
|---|---|---|---|
| #1 | 5 % | #11 | 2 % |
| #2 | 0 % | #12 | 0 % |
| #3 | 0 % | #13 | 0 % |
| #4 | 7.5 % | #14 | 6% |
| #5 | 1.5 % | #15 | 2.5 % |
| #6 | 3 % | #16 | 0 % |
| #7 | 0 % | #17 | 12 % |
| #8 | 0 % | #18 | 0 % |
| #9 | 0 % | #19 | 3.5 % |
| #10 | 5 % | #20 | 0 % |
| 2.4% x 12 |
Total Monthly Net Return of Investment Before Tax Months |
|---|---|
| 51.0% | Affective Annual Yield, Tax-Adjusted |
| 28.8% | Annual ‘in-pocket’ Return Based on Capital Invested |
| + 22.2% | Annual Tax Return Credits through Payback* |
*for Accredited Top Tax BracketVirginia Investor
The table above gives an example of a tax-weighted 2.4% net return a month and an effective, tax-adjusted, 51.0% yield per year. In this example, the investor’s portfolio includes two great wells, one producing a 12% return per month and another 7.5%, and a pool of eight wells producing between 1.5% – 6% net a month.
This also demonstrates how critically important it is to spread your risk over many wells as there could be times when you may participate in two, three, or possibly more non-commercial wells in a row. If you are lucky, or fortunate as we have been, you may wind up participating in less than 50% non-commercial wells, but it is always good to plan, or anticipate a 50% completion and then be “pleasantly surprised” should your returns exceed your expectation.
Success Through Perseverance
Another point to make about the implementation of this diversification strategy is that you must persevere. Ultimate success requires a long-term commitment to your strategy. Suppose the investor in our example had quit after well#3 for a 100% loss, or well#9 where their monthly return would have been ~1.7% actual, which in and of itself is not bad, but that’s as high as it would ever possibly get as the monthly returns will assuredly erode due to the inevitable hyperbolic production decline. Why settle for so little when proper risk-management could return so much more?
Now we want to discuss how oil and gas well returns can be compounded each year to create the most lucrative business venture in the world. We give you two scenarios in the tables below along with a discussion.
The following table is a presentation showing the yearly return and the compounding return each year through
5 years of investing.
- The yearly budget for investing is $1.
- The production is declining at 15% a year.
- 30-Month Payback
| Amount Invested | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Sum Total – Yearly Return | |
| 2018 Portfolio | $1.00 | $0.40 | $0.34 | $0.29 | $0.38 | $0.25 | $1.66 |
| 2019 Portfolio | $1.00 | – | $0.40 | $0.34 | $0.29 | $0.38 | $1.41 |
| 2020 Portfolio | $1.00 | – | – | $0.40 | $0.34 | $0.29 | $1.03 |
| 2021 Portfolio | $1.00 | – | – | – | $0.40 | $0.34 | $0.74 |
| 2022 Portfolio | $1.00 | – | – | – | – | $0.40 | $0.40 |
| Money Earned | (Annually) | $0.40 | $0.74 | $1.03 | $1.41 | $1.66 | $5.24 |
| Cumulative Returns | $0.40 | $1.14 | $2.17 | $3.58 | $5.24 |
As seen in this hypothetical example, by the end of the first year, the investor recovers 40% of their 2018 investment. By the end of year three, the investor has recovered more than 100% of their 2018 investment and has acquired 72% payback on their total portfolio investment to-date. By the end of year five, all “out-of-pocket” investments have been recovered and the returns become “envelope money” or pure profit from this point forward.
The next table changes one assumption that greatly affects the overall return. What if you reinvest your yearly return into wells in addition to your yearly investment budget?
| Amount Invested | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Sum Total – Yearly Return | |
| 2018 Portfolio | $1.00 | $0.40 | $0.34 | $0.29 | $0.38 | $0.25 | $1.66 |
| 2019 Portfolio | $1.00 | – | $0.56 | $0.48 | $0.40 | $0.34 | $1.78 |
| 2020 Portfolio | $1.90 | – | – | $0.40 | $0.34 | $0.55 | $1.96 |
| 2021 Portfolio | $2.53 | – | – | – | $0.40 | $0.86 | $1.87 |
| 2022 Portfolio | $3.44 | – | – | – | – | $1.38 | $1.38 |
| Money Earned | (Annually) | $0.40 | $0.90 | $1.53 | $2.44 | $3.38 | $8.64 |
| Cumulative Returns | $0.40 | $1.30 | $2.83 | $5.27 | $8.64 |
So, if the yearly investment budget is $1 “out-of-pocket” plus the total return of investment from the previous year is reinvested in the current year, then total yield after five years on the “out-of-pocket” is 864%. The ROI on the budgeted out-of-pocket investment, $5, in this hypothetical example is 14.6%. This is before taxes. After taxes, the ROI for a Virginia Accredited Investor at the top marginal Federal tax rate would be ~41.2%.
The conclusions from these return on investment analyses demonstrate the incredible potential one has for building wealth through a prudent and wise application of the comprehensive “strategy for successful oil and natural gas well investing” herein prescribed. The purpose of these charts is solely to demonstrate the power of compounding and reinvesting one’s well income to build a high-performance portfolio. These charts are not intended to represent actual portfolio results through the returns presented are credible in oil and gas investing.
A production decline of 20% per year is closer to the industry average for an individual well. We chose 15% as a conservative estimate for an average decline for a properly managed twenty-well portfolio. If the production decline increases, it can dramatically affect one’s portfolio return. Nevertheless, even with high decline rates, the power of compounding ones’ oil and gas portfolio becomes obvious. There is no other investment vehicle that we are aware of that is consistently capable of returns like these regardless of market trends, perceptions, or values.
Before leaving this discussion, we need to clearly state what we believe to be an acceptable exploratory or “wildcat” prospect. If a prospect does not satisfy these criteria, we recommend that it be rejected as an unsuitable prospect.
- The use of correct mapping techniques and methods are critical to generating reasonable and accurate subsurface interpretations. All subsurface interpretations must be geologically and geometrically valid in three-dimensions.
- The mapping of multiple horizons is essential to develop reasonable and correct three-dimensional interpretations of complexly deformed areas.
- All well control data associated with analogous targets near the prospect have been used in the interpretation.
- Focus on multi-pay objectives (bail-out zones) that allow serendipity to work for you.
- Look for an edge, data that has not been available to industry for one reason or another (example: owned by major who was no longer focusing on this area as a core area)
- Apply the latest available technologies to better define the largest risk factor, i.e., gas effect using new petrophysical algorithms such as WEA, AVO, gathers, and other seismic attributes.
- Generator and/or Operator have proven track records.
Guiding Principles – A Summary
1. Through dollar-cost-averaging spread your drilling budget over dozens of well projects.
2. Try to include as many of the safer offset wells and infield drilling prospects in your portfolio as possible.
3. Exploratory wells as a minimum should have multi-pay zone objectives, validated 3-D seismic interpretation, and associated well control.
4. Only participate in wells that will “probably” (as opposed to possibly) yield a blended annual tax-weighted return through payback of at least 30% and accumulate a reserves base of 3Xs ROI through the life of the portfolio.
5. Plan on a 50% completion rate – continuously strives for 60% or better.
6. Anticipate up to 30% in drilling/completion cost overruns.
7. Expect 15-20% annual production depletion on a balanced well portfolio.
8. Understand that each well is a separate business unit subject to operating expenses and taxes and that any unprofitable well(s) must be quickly identified and divested.
9. And last, but certainly not least, know your prospect generators and operators. Deal only with those that have proven track records and reputations for honest representation and efficient management.
We hope by now that you have gained some perspective on how becoming an oil and natural gas Small Producer can be one of the most lucrative businesses in the world. More importantly, though, we trust that from this brief overview you have gained a much better understanding of what it takes to be a consistent “winner” as a Small Producer of oil and natural gas.
There are significant risks associated with investing in Oil and Gas Ventures. This is not a solicitation to buy or an offer to sell any securities. Any such solicitation or offer will only be made through a private placement memorandum in accordance with Regulation D Rule 506. A thorough discussion of Tax Benefits and Risk Factors associated with this kind of investment are contained within the Private Placement Memorandum.